The Handbook of Credit Risk Management, 2nd Edition

CHAPTER 17Mitigating Derivative Counterparty Credit Risk

Chapter 5 explains why certain transactions, such as derivative transactions or supply/purchase agreements of commodities, generate a type of credit risk called counterparty credit risk. The chapter also explains how to quantify it, which presents a challenge because the exposure amount changes constantly over the life of the contract. Recall that the exposure amount depends on the market value of the product underlying the transaction, such as a commodity, an interest rate, or a foreign‐currency exchange rate, which can vary considerably over time. This is why it is a dynamic exposure and not a fixed one. The more volatile the underlying product, the more uncertain the counterparty credit risk exposure.

It is not surprising, then, that this uncertainty has led to the development of mitigating techniques to make transactions less risky for the parties involved. A firm can have an appetite for, say, interest‐rate risk, but may not want to take the associated credit risk on the counterparty. Similarly, a company may need to lock in the price of a commodity over a long period of time but does not want to be exposed to the risk of loss from its counterparty defaulting prior to the termination date of the contract.

The mitigating techniques work to isolate the risk of default of the counterparty from the underlying contract. What they achieve is to reduce, transfer, or eliminate the credit risk and leave the participants exposed ...